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Michael Lewis on the Hedge Fund Manager Who Saw It Coming

How Steve Eisman made a fortune from the subprime fallout.

How did hedge fund manager Steve Eisman win big off the market meltdown? What will Wall Street look like in five years? In this third and final part of our interview, I put those questions to Liar's Poker author Michael Lewis, editor of the new anthology Panic: The Story of Modern Financial Insanity.

Mac Greer: Now Michael, I want to talk about a guy who seemed to have seen this train wreck coming and made boatloads of money off of it, a guy named Steve Eisman. Paint the picture of who he is, what he did, and how he did it.

Michael Lewis: Eisman is a character I fell in love with. Steve Eisman runs a fund inside a group of funds called Front Point Partners. It is a fund supposedly devoted to investing in financial stocks. He started, I think, you have to probably look at the article and check my own facts, but in 2003, maybe it was 2003, he got into it, 2004? Anyway, his job was to put money to work in the stock market investing in financial stocks. He had been an analyst of financial stocks at Oppenheimer and a famously, coruscatingly skeptical one. He was the man who trained Meredith Whitney, the legendary analyst who has been right about the bust for the last year, and has been kind of singlehandedly, in some cases, driving stock prices down.

Steve Eisman started really digging deeper, once he was investing other people's money, into the current state of the financial system and slowly concluded that there was this madness that was going on, and the madness was the subprime mortgage lending business. He couldn't believe the total absence of credit analysis that was going on before handing people money. Because he didn't understand the fixed-income markets, he had never really dealt with them. He had to learn how these loans got repackaged as bonds, and they get shoved into things called CDOs, and then CDO squareds, and how they got run through these very complicated models and came out the other end as AAA securities.

Greer: And Michael, it is probably worth noting that that fixed-income market that you are talking about dwarfs the stock market.

Lewis: I can't quote Steve Eisman because he uses four-letter words too often, but I think what he said basically was that the stock market is a zit compared to the bond market. He realized this business in investing; he was going to invest in these companies that were in the middle of this madness. It was insane. He wanted to take a position, he takes the position that this is all going to go bad because it seemed like it was all going to go bad to him. He called S&P, the ratings agency, and said, Look, I know you are rating these things AAA, and your model says they are AAA, but what happens if real estate prices go down? And the guys says, Actually there is no place in their model to put a negative number. I can't tell you what happens when real estate prices go down.

He had a gift; he is a really smart guy who refused to be buffaloed by other peoples' gobbledygook. Everybody gets buffaloed by Wall Street doublespeak, and his colleagues say, You loved going to meetings with Steve because he will say over and over again, "Could you say that again? Could you explain that again in English?"

The colleagues say, what you find out when you are in a meeting with Steve is that oftentimes, these Wall Street people actually don't know what they are doing. They don't know what they are talking about, and it doesn't make any sense. They are just kind of repeating what they had been told, and so Steve Eisman did what a number, not a lot, but a handful of smart hedge fund traders did. He went out and he identified pools of subprime mortgages that were particularly obnoxious, particularly terrible. Some in Florida, Inland Empire in California, stuff in Nevada and Arizona, stuff where there had been no documentation, floating rate mortgages, no money down -- loans that have never been made before in the history of mankind. So, having identified the pools and the bonds associated with the pools, he then calls up and strikes a deal with them, and this is the credit default swap market. We won't use that phrase again anymore, but this is the market, the casino and side bets that rose up alongside the subprime mortgage market.

Steve Eisman would pay Goldman Sachs(NYSE:GS) and Deutsche Bank(NYSE:DB) X% of the principle amount a year, say 10% or 8%. In exchange, if the subprime mortgage pool goes bad, Deutsche Bank or Goldman Sachs has to pay Steve Eisman the whole principle. So, if he is betting on, as he did, say $500 million of subprime mortgages, and he wants to short them, he pays $5 million a year to do that, but if all of a sudden they go bad, they have to pay him $500 million. I don't know; those numbers aren't exactly right, but in any case, that is the idea.

So, he shorted the subprime mortgage market by picking the best things to short. And what is amazing is that these firms created this casino in these bets, and that casino is bigger than the original market. So when you look at what is going on now and you are mystified why the Treasury and the Fed and whoever else is throwing money at them, is throwing $150 billion at AIG(NYSE:AIG) to prevent it from going down and you ask why is an insurance company getting $150 billion in this crisis? What is that about? Well, what that's about is that Goldman Sachs, having taken Steve Eisman's side bet, turned around and laid it off on AIG. And AIG foolishly, essentially, ensured the subprime mortgage market. So, what the Treasury is doing is paying off AIG's bad debts to Goldman Sachs, so the money goes to AIG just so it can go to Goldman Sachs, so it can go to Steve Eisman.

Greer: Now Michael, I know one thing that comes through a lot of your writings is that you keep waiting for there to be a great reckoning on Wall Street. In this case, do you think that the game has changed, and what are going to be the lessons of this meltdown? Are they going to last?

Lewis: Yes, the game has changed. There is a long answer to that question, but I think the short answer is that the structure of the financial system is going to change as a result of this, and compensation in the financial system is going to change.

Greer: So, what does Wall Street look like in 25 years?

Lewis: Oh, that is a long time. Let's talk five.

Greer: OK, five years.

Lewis: In five, there are many fewer fancy seats and they are in smaller institutions called hedge funds. A job at Goldman Sachs is about as glamorous as a job at the Chase Manhattan Bank was in 1985 -- it's just not what the brightest sparks want to do. The neatest jobs in finance are venture capital and private equity, but they are smaller, niche jobs. Generally, the financial services sector shrinks quite a bit. There are many fewer people making, taking financial risks.

Greer: And so Michael, I know after Liar's Poker, you had said that you hoped that "some bright kid, say at Ohio State University, who really wanted to be an oceanographer, would read my book, spurn the offer from Morgan Stanley and set out to sea." So are we going to see more oceanographers?

Lewis: I think they are not even going to want to read my book. I think this era on Wall Street will have finally come to an end, and people will look at Liar's Poker as a document from the distant past.